What follows is a transcript of the video recording.
Let’s try a practice question:
Which of the following yield is the highest for a bond trading discount?
- Current Yield
- Nominal Yield
The best answer is “B,” a yield-to-call. Yield-to-call generally is the highest yield, great discount bond. Let’s look at each of the options.
What Is Nominal Yield?
Nominal yield is the fixed annual interest. Let’s say you have a bond that pays 9% interest. By the way, 9% is 9% of par, with par value being $1,000 per bond. That means it pays 9% of $1,000 or $90 a year. That is your nominal yield. It is fixed over the life of the bond, fixed 9%.
What Is Current Yield?
Does anyone know the formula for current yields? Current yield is annual interest divided by the market price of the bond. Annual interest is divided by the market price of the bond. Let’s say you have your annual interest, which is $90. And let’s say we have a discount bond, like in this question. Well, let’s say our bond is worth $900. So, if you take $90 of annual interest divided by a market price of $900, just making up that number, you get a yield somewhere above 9%. So, 90 over 900 would be a current yield of 10%.
“Current Yield = Annual interest divided by the market price of the bond.”
What Is Yield-to-Maturity?
For yield-to-maturity and yield-to-call, you will not have to calculate these on the exam. Yield-to-maturity reflects the yield that is earned, if a bond is held until maturity. Let’s say you buy a bond today for $900 that matures in 10 years.
“Yield-to-maturity reflects the yield that is earned, if a bond is held until maturity.”
in this case, when the bond matures in 10 years, how much money does the investor get? How much principle does an investor receive back at maturity? They received back $1,000 right? You always get back your par of a thousand. In this case, you’re paying $900 to buy the bond, but in 10 years, you’re going get back $1,000. Over the next 10 years effectively, you’re going make $100 extra dollars. You pay $900, and you get back $1,000 at maturity. Basically, yield-to-maturity reflects that extra $100 that you are getting over the next 10 years. And because of that, it reflects not only the coupon, but also this extra $100 you are going to make over the next 10 years. It’s going to push your yield higher.
What Is Yield-to-Call?
It’s yield that is earned if a bond is called away by the issuer prior to maturity. What I mean by that is, let’s say you have the same 10-year bond at $900. It matures in 10 years, but the issuer buys back the bond after year 5. Well thinking about it for a second, instead of having to wait the full 10 years to get back our principal, in this yield-to-call scenario, we will get our money back after year 5 years. We will make that same $100 but rather than stretching that $100 over 10 years, we are making that same $100 over five years. Put differently, that $100 game is accelerated over a fewer number of years. We are getting our money back more quickly. And for that reason, for a discount bond, yield call is the greatest because it reflects you get back that additional juice, the most quickly. You might see a question on the exam like this, about the different yields.